Capital structure – doesownership structure matter?Theory and Indian evidence

Santanu K. GanguliInstitute of Management Technology – Ghaziabad, Ghaziabad, India

Abstract

Purpose – Based on the agency theory, the purpose of this paper is to theoretically argue andempirically investigate how ownership structure impacts the capital structure of the listed mid-capcompanies in India and whether the capital structure as exogenous variable has a role in determiningownership structure as well.

Design/methodology/approach – Simultaneity between capital structure and ownership structureis checked through Hausman specification test on endogeneity. Fixed effect panel regression model isused to analyze five years of data (2005-2009) on the sample units, to find the relation between leverageand ownership structure after controlling for profitability, risk, tangibility, growth and size.

Findings – Empirical results on Indian firms suggest that the ownership structure does impactcapital structure but not the vice versa. Consistent with theoretical prediction empirical results revealthat the leverage is positively related to concentrated shareholding and has a negative relation withdiffuseness of shareholding after controlling for profitability, risk, tangibility, growth and size.The findings are consistent with “managerial entrenchment hypothesis” and “pecking order theory” ofcapital structure.

Practical implications – The findings of the paper will enable the practitioners and analysts tounderstand as to why, in the bank and financial institution-dominated debt financing system in India,leverage is closely associated with concentrated ownership pattern and why retained earning is apreferred vehicle of financing for the firms with diffused shareholding.

Originality/value – The results of the study enrich the literature on capital structure, agency costand corporate governance issues in several ways.

Keywords India, Corporate ownership, Capital structure, Ownership structure, Agency theory,Concentrated shareholding, Diffused shareholding, Entrenched manager

Paper type Research paper

1. IntroductionEver since publication of the seminal paper of Modigliani and Miller (1958) as regardsthe role of capital structure decision on firm value, there have taken place phenomenalresearch on the topic both theoretical and empirical – leading to creation of huge bodyof literature in last 52 years.

The original simplistic assumption by Modigliani-Miller (MM) of no tax was alteredto factor in the impact of tax shield of interest expenses involved in debt financing.This lead to evolution of “trade off” theory of capital structure. Besides trade off theory

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/1086-7376.htm

JEL classification – G 32, G 34The author wishes to sincerely thank colleague Debabrata Datta – Professor of Economics,

Institute of Management Technology, Ghaziabad (India), the Editor, Associate Editor andanonymous referees for their valuable comments and suggestion. The author takes responsibility forany shortcomings and mistakes.

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Studies in Economics and FinanceVol. 30 No. 1, 2013pp. 56-72q Emerald Group Publishing Limited1086-7376DOI 10.1108/10867371311300982

the other two most important theoretical developments have been “pecking order”theory by Myers (1984) and “agency theory” of debt by Jensen and Meckling (1976).

Moreover, a number of empirical papers have come into existence in almost all thecountries (wherein private capital plays a major role in the economy) to investigate thevalidity of the theories so far developed. Besides verifying theories, the empiricalstudies have been able to highlight a range of major determinants of capital structurelike profitability, risk, tangibility, growth, size, corporate governance and agency costto the advantage of practicing finance professionals and analysts. In fact the field ofinvestigation is ever increasing.

In last two decades the role of corporate governance in finance has developed as adistinct and dominant area of research. Empirical papers documenting relationshipbetween corporate governance and capital structure are comparatively more of recentorigin. According to Shleifer and Vishny (1997) corporate governance deals with theways in which the suppliers of finance to the corporations assure themselves of getting areturn on their investment. Accordingly, the main and the long term supplier of finance– that is, the outside equity shareholders must ensure themselves of getting return ontheir investment in the company. The problem arises when there is separation ofownership and management. The problem is one of principal and agent. When thescattered outside investors provide fund to promoters or professional managers theformer have little to contribute afterwards, the latter can well run away with the money.In sporadic cases they do but normally they do not. Most market economies have devisedsystem and mechanism by which the dispersed shareholders can monitor the managers.“Agency theory” posits that debt acts as a disciplining mechanism as the lendersmonitor the action of the managers. Corporate governance literature is concerned withthe resolution of collective action problem confronted by the dispersed shareholdingpattern of the corporations. In all countries one of the most favored mechanisms forresolving the collective action problem appears to be partial ownership and controlconcentration in the hands of one or few large shareholders (block holding) as theirinterest is more intensely aligned with the firm. Because of alignment of interest, theblock shareholders monitor the action and decisions of professional managers closelyand therefore may be looked upon as a mitigating device of agency problem in case ofseparation of ownership and management. The argument leads to the research question– if both debt and concentration of shareholding act as mitigating device of conflict ofinterest issue between managers and share holders then what could be the possiblerelation between debt (leverage) and concentration of shareholding?

On the other hand when the shareholding is dispersed the managers are subjected tolesser monitoring and scrutiny by the shareholders. Managerial discretion is muchmore in case of dispersed shareholding. In such case the management will take financingdecisions in a manner that prevents concentration of shareholding. If debt is raised forfinancing, the managers can avoid insiders monitoring but subject themselves tomonitoring by the lenders. So what is preferable to entrenched managers, insidemonitoring by large shareholders or monitoring by the lenders? The question is ofparamount importance as Myers (2001) observes that firms presumably act in theinterest of some group or coalition of managers who make or are affected by the financialdecisions of the firm.

Elaborating on the above argument of agency issue we reason and empiricallyinvestigate how and to what extent ownership structure impacts the capital structure

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of the listed mid-cap companies in India. We also argue and explore (empirically)whether the capital structure as exogenous variable has a role in determiningownership structure as well. Our empirical models besides taking into considerationconcentration (and dispersion of shareholding) as determinants of capital structureaccount for profitability, risk, tangibility, growth and size of the sample firms as othercontrol variables.

The results of the study enrich the literature on capital structure, agency cost andcorporate governance issues in several ways. First we provide a theoretical reasoningbased on corporate governance and agency theory literature that there should exist apositive relation between leverage and concentration of holding. We argue that thehigher debt coupled with concentrated shareholding might help in resolving collectiveaction problem and reducing managerial discretion. Using the Indian context and dataset we put the argument to empirical taste and find a positive relation between leverageand ownership concentration. Margaritis and Psillaki (2010) record similar empiricalfinding for French manufacturing companies. We provide an explanation for the resultas well. Pindado and De La Torre (2011) record that the larger debt increments arepromoted by outside owners when managers are entrenched. In Russian context Poyryand Maury (2010) observe that the firms with owners having political influence or tiesto large financial groups have better access to debt.

Second we find a negative relationship between leverage and diffuseness of holding.We provide a new line of reasoning for the negative relation in addition to “managerialentrenchment” argument put forward by Kayhan (2008) in respect of lesser use of debtby the self-interested entrenched managers. We argue that if the entrenched managersare not subject to large shareholders’ scrutiny, they sought to avoid external scrutinyby lenders as well using retained earning or issue of equity for investment rather thangoing for debt financing. The result is likely to enhance agency problem as themanager is neither subject to scrutiny by block shareholders nor lenders.

Third in the process of building our empirical model we blend ownership structurethat addresses collective action problem by the shareholders with other controlvariables like profitability, risk, tangibility, growth and size determined empirically byprevious studies (the other control variables generally support “trade off” and “peckingorder” theory one way or other) to show the cumulative impact on capital structure.Last though we extend theoretical reasoning from agency perspective that theownership structure as endogenous variable should be impacted by capital structure aswell, but we find little empirical support for the argument based on Indian data set.

The remainder of the paper is organized in the following way. Section 2 discussesmain theories, empirical determinants of capital structure and hypothesis. Section 3describes the data and empirical model. Section 4 details the empirical result andSection 5 concludes with summary of findings.

2. Theories, empirical determinants and hypothesesThe paper dealing with irrelevance of debt in capital structure for determining firmvalue by Modigliani and Miller (1958) included a number of assumptions – one ofwhich was absence of corporate tax. Subsequently in 1963 when the corporate tax wasfactored in the model by them (MM), it was found that theoretically the value of a firmshould increase with debt because of interest tax shield (Modigliani and Miller, 1963).But monotonic increase of debt for higher tax shield increases bankruptcy cost

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specially when profitability is low and fluctuating. This leads to “trade off” theory ofcapital structure that postulates an optimum debt level or target level – at whichmarginal increase of present value of tax saving is just offset by the same amount ofbankruptcy cost. Though exact target debt level may not be determined objectively ina given situation, the theory explains the fact that there is a limit to debt financing andthe target debt varies from firm to firm depending on profitability, size, composition ofassets deployed, risk (fluctuation in profitability), growth and so on. A firm havinghigh and consistent profitability with lot of tangible assets that can be offered ascollateral security for debt should have a higher target debt ratio.

Consistent with the trade off theory Alderson and Betker (1995) using log (assets) asproxy for firm size found a positive relationship between leverage and asset. Titmanand Wessels (1988) and Wiwattanakantang (1999) using log (sales) as proxy for firmsize found positive but insignificant relationship between leverage and firm size.Similarly, as far as tangibility is concerned Galai and Masulis (1976), Myers (1977) andMyers and Majluf (1984) stressed the impact of asset structure on firm’s financialpolicies. As the carrying amount of assets that can be offered as collateral securityincreases – debt capacity increases. The asset composition may be broadly foundeither by the ratio of liquidation value of tangible asset to total assets or by the ratio ofintangible asset to total assets. If the first one is considered then there should be apositive relationship with leverage and in the second case there should be a negativerelationship. Consistent with trade off theory Rajan and Zingles (1995), Jordon et al.(1998), Wiwattanakantang (1999) and Hirota (1999) found a positive relation betweentangible assets and debt. Titman and Wessels (1988) using the standard deviation ofthe percentage change in operating income as proxy for risk found negative butinsignificant inverse relationship between risk and leverage. A recent study onBrazilian firms by Correa et al. (2007) uses variance of operating profit to total assets asproxy for risk and found a positive relation with leverage confirming the result foundby Jordon et al. (1998) and Wiwattanakantang et al. The findings run counter to tradeoff theory. Increase of debt should enhance volatility of earning because of interestexpenses as such there should be a negative relation. Hirota (1999) found a negativerelation between the two. Rajan and Zingales et al., Wiwattanakantang et al. andHirota et al. using market to book value ratio as measure of growth found that withdecrease in growth opportunities, leverage increases. The finding is consistent withtrade off theory. Titman and Wessels et al. using percentage change in asset, capitalexpenditure and R&D expenditure as proxy for growth find no significant relationship.

In reality it is found that a number of successful firms with high and consistentprofitability hardly goes for debt financing. This leads to an alternative theory offinance called “pecking order” theory developed by Myers (1984). The origin of peckingorder theory is asymmetric information – implying that the managers know moreabout a company’s prospect than the outside investors. The theory suggests that if afirm issues equity shares to finance a project, it has to issue shares at less than theprevailing market price. This signals that the shares are overvalued and themanagement is not confident to serve the debt if the project happens to be financed bydebt. Thus, issue of shares is “bad news”. On the contrary if external borrowing is usedto finance the project, it sends a signal that the management is confident of the futureprospect of serving debt. Hence debt is preferred over shares in financing decision.Nevertheless, pricing of debt instrument remains a problem in view of interest rate risk

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and default risk. With regard to price of debt, investors may remain skeptical in thesame manner as pricing of the equity. To avoid controversy as regards informationcontent of pricing the management may wish to finance project by retained earningonly. Thus, financing follows an order, first – retained earning, then-debt and finallywhen debt capacity gets exhausted – equity. This explains why the profitable firmsuse less/negligible debt. Rajan and Zingles (1995) using earning before interest, taxesand depreciation (EBIDTA) scaled by book value of assets as measure of profitabilityfound a negative relationship with the leverage. Titman et al. using operating incomescaled by total assets and margin as measure of profitability found a negative relationwith leverage. Hirota et al. found an inverse relationship between EBIDTA/total assetsand leverage. The findings are consistent with pecking order theory.

Though debt reduces agency conflict (and cost) between managers andshareholders but at the same time according to Jensen and Meckling (1976) it leadsto agency problem between the shareholders and debt holders.

The entrenched managers instead of pursuing value maximizing objective ofshareholders may indulge in self-dealing particularly when shareholding is scattered.Indirect agency cost occurs when the managers do not strive enough to maximize theshareholders’ value. In that case shareholders have to monitor the behavior of theshareholders involving direct agency cost. Thus, there are both direct and indirectagency costs arising from equity financing in case of separation of ownership andmanagement. Debt partly resolves this problem. When a firm is financed by debt, themanagement is induced to minimize wasteful expenditure and optimize operatingefficiency for servicing debt as per covenant. Debt monitors action and behavior of themanager. But when the debt is high and the company faces financial distress, if thereare two projects one is risky with high pay off and the other is less risky with low payoff, the management may be induced to invest fund in risky projects having high payoff. If the project is successful the shareholders will have residual cash flow afterpaying off the debt. If the project fails, the loss is mostly borne by the creditors as theliability of shareholders is limited. Thus, in case of debt financing, the shareholdersencourage management to take such decisions which, in effect, expropriate fund fromcreditors to shareholders. The debt holders being aware of such risk will ask for higherrate of interest and insist on inclusion of restrictive covenants in debt agreement tomitigate the conflict of interest (agency problem between the shareholders and the debtholders). Agency cost of debt arising from higher cost of finance and restrictionimposed by covenant having a bearing on future cash flow is to an extent compensatedby lowering agency cost (of equity financing) that arises from separation of ownershipand management. In an empirical paper Jiraporn and Gleason (2007) show an inverserelation between leverage and shareholders right suggesting that the firms adopthigher debt ratios where shareholders’ rights are more restricted. This is consistentwith agency theory which predicts that leverage helps alleviate agency problem.

Among some recent studies Margaritis and Psillaki (2010), Pindado and De La Torre(2011) and Poyry and Maury (2010), respectively, record relationship between leverageand various types of ownership pattern based on concentration, interest groups andinfluence. Kose and Litov (2010) argue that firms with entrenched managers use moredebt contrary to earlier views that suggest entrenched managers employ less debt.Among earlier studies Bernstein (1994) posits that the theory of agency cost andimperfect information suggest that some types of firms may prefer to finance

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investment with internal funds. The results by Brailsford et al. (2002) in the context of49 Australian firms indicate a nonlinear inverted U-shaped relation between the levelof managerial ownership and leverage. They observe beyond a point there is potentialfor increase in managerial opportunistic behavior associated with decrease of debt. Thestudy also indicates a positive relation between block ownership and leverage.Drieffield et al. (2007) in their study on impact of ownership structure on capitalstructure and firm value for the East Asian countries (Korea, Indonesia, Malaysia andThailand) distinguish owner managed family firms from non-family firms not beingowner managed. They find that the effect of concentration (of ownership) differbetween the two groups of firms. Higher concentration increases leverage in familyfirms but tends to lower it among non-family firms in Indonesia, Malaysia andThailand.

2.1 Shareholding pattern and capital structureAs far back as in 1932 in a classic paper Berle and Means (1932) envisioned a scenarioof extreme dispersion of shareholding pattern. They predicted that the diffusedshareholding of big corporations would progressively leave more power in the hands ofthe managers. Individual shareholders would have little incentive to monitor themanagerial action and at the same time the managers’ ownership right in suchcorporations would be so less that they would be hardly interested to enhance the firmvalue. Thus, too much dispersion of shareholding leads to agency problem for lack ofcontrol right by fragmented individual shareholder. As direct antidote the straightforward way to align cash flow and control right is concentrated shareholding (Shleiferand Vishny, 1997). If the voting control is concentrated in the hand of a few largeshareholders they can put pressure on the management to perform or else replacethrough a proxy fight or take over. Large shareholder/s address the agency problemand even can control the management directly specially when they hold more than50 percent ownership right. Their interest is much more aligned for profitmaximization and they will force the management to take such strategic decision infinance and non-finance matters so that their interest remains respected and protected.Naturally the large shareholders will have an interest in establishing and continuingwith such capital structure that ensures their ownership right of control overmanagement. If fund is required for capital investment, the large shareholders preferdebt financing as debt normally does not carry voting or control right till principal andinterest are served as per debt covenants.

2.2 Indian contextIn India corporate debt market is yet to develop and flourish like its westerncounterparts. India, after independence in 1947, for over four decades embracedsocialistic pattern of development where public sector banks and financial institutionslargely met the requirement of debt finance by the corporate sector. Since liberalizationin early 1990s, though equity segment of capital market has almost become asdeveloped as any other advanced market economy, corporate debt segment is yet tocatch up with the trend. Still today the public sector banks and financial institutionsplay a major role in providing debt finance of the private corporate sector and suchfinancing is highly collateral security based. In case of concentrated shareholding, theinterest of the block shareholders being more aligned to the company – for raising loan

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(from banks or financial institutions) they either mortgage their personal propertyor property of the associate companies of which they are the principalshareholders-managers as collateral security or stand guarantor for repayment ofloan. This aspect plays an important role in reducing overall agency cost of debt asprovision for collateral security reduces cost of finance as well as cost of monitoring.

There exist variations when it comes to selecting a proxy for measuring ownershipconcentration. In measuring concentration on firm performance, Demsetz and Lehn(1985) use fraction of shares held by five largest shareholders as a measure ofconcentration of ownership structure as they are more likely to control professionalmanagement. Morck et al. (1988) and Cho (1998) focus on fraction of shares owned bythe management consisting of board members, CEO and top management as measureof concentration. Welch (2003) summarizes the situation by observing that both –fraction of shares owned by top five shareholders representing outside shareholders’ability to control management action as well as fraction of shares owned by themanagement representing latter’s ability to ignore former should be considered forfinding impact on firm performance.

In India promoters’ and non-promoters’ holding are two distinct group ofshareholders and may be considered as proxies for concentration and diffuseness ofownership, respectively. According to the market regulator Securities Exchange andBoard of India (SEBI) – the promoter has been defined as a person or persons who arein overall control of the company or persons, who are instrumental in the formulationof a plan or programme pursuant to which the securities are offered to the public andthose named in the prospectus as promoters (www.sebi.gov.in). Hence, in Indiancontext, by definition the promoters are the persons or group who continue to remain inoverall control over the resources of a company in the post public offering. Forprotection of the investors SEBI requires that in post public offering the promotersmust continue to hold 20 percent shares for a minimum of three years. Obviously thepromoters may continue to hold more shares or off-load (shares) subject to abovestatutory requirement. As per the companies law of India – one equity share carriesone vote. Over 50 percent holding of equity shares directly or indirectly throughpyramidal holding or cross holding gives direct right to determine composition ofboard and legal control though cash flow right may be different. CEO and otherexecutive directors may either be direct representatives of the promoters or actingmerely in the professional capacity subject to the direction and control of thepromoters. Hence, shareholding by the promoters can be taken as proxy forconcentration. By implication non-promoters are those who are not promoters. In theevent of relatively more non-promoters’ shareholding, independent professionalmanagers are likely to enjoy more flexibility and freedom as they are not subject todirect control by any dominant group (promoters). Non-promoters’ shareholding can beconsidered as proxy for diffuseness of shareholding.

Given the Indian context we argue that the promoters’ shareholding increasescapacity of a firm to go for debt financing. On the contrary, issue of equity shares forfinancing may lead to dilution of existing voting control. Hence, debt would bepreferred even if that leads to partial monitoring of managerial behavior by the lendersas that does not impact shareholders’ voting control directly.

Diffuseness of holding gives managerial discretion which a manager is unlikely toforego. Any change in the capital structure leading to concentration of holding may

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reduce such discretion. According to Jensen (1986) the managers of the firms try tofinance investment by internally generated fund. If there is free cash flow, the managerscan either pay dividend or retain the fund for future investment. If free cash flow ispaid as dividend the manager has to approach either the capital market or debt marketfor financing new investment. In either case he subjects himself to monitoring bycapital market or debt holder. Particularly debt reduces free cash flow in the hands ofthe manager to fulfill commitment for interest payment and principal repayment.In case of diffused shareholding where internal monitoring is negligible the managerwill try to avoid external monitoring also by funding projects internally through totalor partial restriction on dividend payout. Jensen (1986) terms the phenomenon asagency problem of free cash flow as it creates opportunities for managers to spendmoney on costly perks or misuse fund on acquisition that does not enhance value of theshareholders in the long run.

In case of dispersed non-promoters’ shareholding we are likely to witness less ofdebt and more of financing through retained earning. If retained earning is notadequate, there would be right issue of shares proportionate to existing ownership andvoting right in a manner that does not result in concentration of holding.

Thus, promoters’ shareholding (concentration) and non-promoters’ shareholding(diffuseness) besides determinants like profitability, size, risk, growth, tangibility andso on should play a role in determining capital structure or leverage. At the same time,capital structure should also be a determinant of ownership structure as blockshareholders would be inclined to follow a financing pattern that would enable toretain their control and in case of diffused shareholding, managers have an incentive tomaintain a capital structure that would not come in the way of upsetting managerialdiscretion. There should be a two way relationship between capital structure (leverage)and concentration or diffuseness.

In Indian context the article has the following hypotheses with regard to theleverage, promoters’ and non-promoters’ shareholding:

H1. After controlling profitability, risk, tangibility, growth and size, leverage haspositive relation with promoters’ shareholding.

H2. Promoters’ shareholding as endogenous variable is impacted by leverage.

H3. After controlling profitability, risk, tangibility, growth and size, leverage hasnegative relation with non-promoters’ shareholding.

H4. Non-promoters’ shareholding as endogenous variable is impacted byleverage.

3. Data and empirical modelThe study uses the list of CNX Midcap index companies as its sample. The list consistsof 100 companies representing diverse sectors of the economy. The index is calculatedby the National Stock Exchange (NSE) using market capitalization weighted method.The process ensures exclusion of the first 50 biggest stocks in terms of marketcapitalization. Similarly, small companies accounting for 75 percent of the marketcapitalization from bottom are excluded. The sample selection process avoids inclusionof outliers – too big and too small companies so far as size (in terms of marketcapitalization) is concerned.

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We collect relevant data to compute variables namely leverage, profitability,tangibility, size, growth, promoters’ and non-promoters’ share holding from “prowess”data base of the Centre for Monitoring Indian Economy (CMIE) for five financial yearsfrom 2004 to 2009 for analysis. Out of 100 companies we exclude banks andnon-banking finance companies as per usual practice as their financial characteristicsare quite different from others. The sample size gets reduced to 81 companiesrepresenting almost all the major sectors of Indian economy except banking andfinance sector.

We set two sets of simultaneous equation models consisting of two equations in eachset. In set 1 we take leverage as endogenous and promoters’ shareholding as endogenousexplanatory variable together with other control variables as exogenous orpredetermined. In second equation we take promoters’ shareholding as endogenousand leverage as endogenous explanatory variable. In set 2 we take leverageas endogenous and non-promoters’ shareholding as endogenous explanatory variabletogether with other control variables as exogenous or predetermined. In the equation (2)we take non-promoters’ shareholding as endogenous and leverage as endogenousexplanatory variable. It is necessary to formulate two sets of regression equationbecause inclusion of both promoters’ and non-promoters’ shareholding in the sameequation will lead to near-perfect multi-collinearity as by definition if promoters’ holdingis p, non-promoters’ holding will be (1 2 p). Our empirical results will not be robustunless we report the impact of both forms of ownership structure (concentrated anddiffused) on capital structure.

To capture the relationship between leverage and ownership structure we formulatetwo pairs of simultaneous equation models as under (Table I):

Set 1:

LEVit ¼ a1 þ a2PROFITit þ a3RISKit þ a4TAN þ a5GROit þ a6SIZEit

þ a7PSHit þ uit

ð1Þ

PSHit ¼ l1 þ l2LEV it þ vit ð2Þ

Set 2:

LEV it ¼ b1 þ b2PROFITit þ b3RISKit þ b4TANit þ b5GROit

þ b6SIZEit þ b7NPSHit þ 1it

ð3Þ

NPSHit ¼ d1 þ d2LEV it þ jit ð4Þ

In case of simultaneous equation models, econometricians argue that OLS methodshould not be used because the estimators thus obtained lead to bias andinconsistency in presence of endogeneity. In such case two stage least square (2SLS)model resolves the problem. Again, according to Wooldrige (2009, Econometrics),2SLS estimate is less efficient than OLS when explanatory variables are exogenous.Hence, we perform endogeneity test in order to find whether 2SLS is at allnecessary.

Then we use fixed effect panel regression model to analyze data of five years(2004-2009) on the sample units. In the fixed effect regression model, in equations (1)and (3) we estimate two additional variables gi and Vt that, respectively, capture all

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unobserved firm specific time invariant factors and year specific unobserved factors(but not varying over firms) along with the other explanatory variables impactingleverage.

The sample altogether consists of 405 observations.

4. Empirical resultOut of 81 companies, promoters’ shareholding being overall more than 50 percent hasbeen witnessed in case of 48 companies. Putting differently in about 60 percent cases,the promoters hold more than 50 percent of the total equity shares. Promoters’shareholding for the sample companies averages 55 percent. The figures indicatedominance of concentrated holding pattern in Indian context. The finding is consistentwith that of La Porta et al. (1998, 1999) and Ganguli and Agrawal (2009). In a recentstudy, Holderness (2009) reports that the popular belief of comparatively more

Variables Definition and explanation

LEV Capital structure or leverage has been measured by dividing the book value of total ofsecured and unsecured loan by the book value of total assets at the end each financial yearfrom 2005 to 2009. Total assets is the total of assets as per balance sheet minus deferred taxasset and misc. expenses appearing on the asset side – both considered as arising out ofaccounting adjustment only

PROFIT Profitability ¼ EBIT/Total Assets, where EBIT is the operating profit, that is, earningbefore interest and tax during the study period 2005-2009

RISK Risk has been measured in terms of the variance of profitability during 2005-2009,

RISK ¼EBIT

TotalAssets

�2

EBIT

TotalAssets

�2

TAN Tan denotes tangibility measured as under:

Tangibility ¼PropertyPlant & Equipment þ Inventory þ Debtors

TotalAssets

In a number of studies, only property plant and equipment together with inventory areconsidered for measuring tangibility. We include debtors as well – as part of tangibleassets. In case of manufacturing and trading firms, debtor is nothing but inventory lying atthe risk of customers. For service providers debtor means service provided for which rightto receive payment has accrued. In both the cases, good debtors enable a firm to raisefinance through bill discounting and other modes, as such, is treated as a part of thetangible assets

GRO GRO denotes growth. It is defined as growth of sales and is measured for the ith firm attime t as under:

Growthit ¼Salesit 2 Salesiðt21Þ

Salesiðt21Þ

SIZE Natural log of the book value of total asset at the end of each financial year during 2005-2009 has been used as proxy for size

PSH The ratio of promoters shareholding to total shareholding at the end of each financial yearduring 2005-2009. The ratio has been used as proxy for concentration of shareholding

NPSH The ratio of non-promoters shareholding to total shareholding at the end of each financialyear during 2005-2009. The ratio has been used as proxy for diffuseness of shareholding

Table I.Definition of variables

with explanation

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diffuseness of US corporations is a myth. Block holders in US public companies on anaverage own 39 percent of the shares.

Table II presents the descriptive statistics in respect of cross-sectional as well aspooled data. Table III shows the correlation matrices (based on pooled data) among allthe variables.

4.1 Result of testing endogeneity/simultaneity (Hausman test of endogeneity)In our set 1 of equations we have LEV and PSH as endogenous variables, the restare exogenous or predetermined variables (Hausman, 1976). We regress (by poolingcross-sectional values) LEV on the reduced form of structural equation to getthe predicted value of LEV and residuals. Again, we regress PSH on predicted value ofLEV and residual. If the coefficient of residual is zero, then PSH is not endogenous.The result of regression of PSH on PLEVP (predicted value of LEV in case ofpromoters holding) and RESIP (residual of leverage for promoters holding) is givenin Table IV.

In set 2 of equations we have LEV and NPSH as endogenous variables. In the sameway we produce the result of regression of NPSH on PLEVN (predicted value of LEV incase of non-promoters holding) and RESIN (residual of leverage for non-promotersholding) in Table V.

From the Tables IV and V above we find that the coefficients of residuals are notsignificantly different from zero. We accept that promoters’ shareholding(concentration) and non-promoters’ shareholding (diffuseness) are not endogenous.We reject the H2 and H4. In other words ownership structure is not dependent uponcapital structure.

4.2 Fixed effect panel regression resultThe result of the fixed effect regression showing the relation between leverage andpromoters’ shareholding is provided in Table VI.

The result of the fixed effect regression showing the relation between capitalstructure and diffuseness is provided in Table VII.

The results of the fixed effect regression presented in Tables VI and VII reveal thatafter controlling for firm and year effects, concentration is positively related to capitalstructure whereas diffuseness is found to be negatively related. The result issignificant at 5 percent level. Profitability is negatively related to capital structure andthe relation is statistically significant at 1 percent level.

Tangibility is found to be negatively related to leverage and the result isstatistically significant at 10 percent level. The finding is counter-intuitive in the sensethat higher tangibility means availability of more collateral securities, hence thereshould be a positive relation between the two. The coefficients of risk and size arenegative and the coefficient of growth is positive but all of them are insignificantstatistically. The finding of statistically insignificant relation of leverage with risk, sizeand growth is consistent with that of Titman and Wessels (1988). Further our result isrobust and there seems to be no omitted variable bias.

5. Summary of findings and conclusionGrounded on agency theory, in the present paper we have put forward an argumentas regards the likely relation between ownership structure and capital structure.

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1.70

RIS

K0.

003

0.00

10.

005

4.14

0.00

20.

000

0.00

34.

790.

002

0.00

00.

003

3.01

0.00

20.

001

0.00

33.

640.

003

0.00

10.

007

3.44

0.00

20.

001

0.00

44.

23T

AN

0.70

0.76

0.22

0.97

0.67

0.73

0.22

20.

780.

650.

710.

222

0.76

0.64

0.70

0.23

20.

700.

620.

670.

232

0.66

0.66

0.71

0.22

20.

75G

RO

0.24

0.20

0.26

1.34

0.27

0.20

0.28

2.00

0.33

0.24

0.42

2.93

0.34

0.20

0.54

4.33

0.18

0.16

0.29

1.77

0.27

0.20

0.38

3.90

SIZ

E7.

077.

071.

040.

047.

367.

250.

910.

627.

687.

590.

810.

767.

977.

950.

810.

668.

168.

130.

810.

587.

657.

610.

960.

13P

SH

0.56

0.54

0.18

0.23

0.55

0.52

0.19

0.28

0.54

0.52

0.18

0.30

0.54

0.51

0.18

0.29

0.55

0.51

0.18

0.27

0.55

0.52

0.18

0.27

NP

SH

0.44

0.46

0.18

20.

230.

450.

480.

192

0.28

0.45

0.47

0.18

20.

240.

450.

480.

182

0.22

0.44

0.48

0.18

20.

200.

450.

470.

182

0.23

Note

:M

N–

mea

n,

MD

–m

edia

n,

SD

–st

and

ard

dev

iati

onan

dS

K–

skew

nes

s

Table II.Descriptive statistics

Capital structure

67

Variables LEV PROFIT RISK TAN GRO SIZE PSH NPSH

LEV 1PROFIT 20.39516 1RISK 20.05201 0.31820 1TAN 0.24798 20.01721 0.06625 1GRO 0.04628 0.04307 0.06977 0.01210 1SIZE 0.25573 20.32576 20.09875 0.14651 20.01675 1PSH 20.12067 0.08526 0.15013 20.09166 0.02611 20.24527 1NPSH 0.13158 20.0729 20.14032 0.10037 20.01823 0.22429 20.98743 1

Note: The figures in the table reflect no serious multicollinearity problems among the explanatoryvariables of the regression models used

Table III.Correlation matrices

Variables Coefficient t-statistics

Constant 0.610 23.444 *

PLEVP 20.272 22.670 *

RESIP 20.0498 20.892R 2-value 0.019

Note: Significance at: *5 percent level

Table IV.Regression result of PSHon PLEVP and RESIP

Variables Coefficient t-statistics

Constant 0.026 15.093 *

PLEVP 20.253 22.503 *

RESIP 20.068 1.223R 2-value 0.019

Note: Significance at: *5 percent level

Table V.Regression result ofNPSH on PLEVN andRESIN

Explanatory variable Coefficient t-statistics

Constant 0.216 1.257PROFIT 20.288 23.177 *

RISK 20.945 20.794TAN 20.089 21.695 * * *

GROWTH 0.017 1.271SIZE 20.016 21.089PSH 0.450 2.777 *

R 2 0.850F-value 19.618DURBIN-WATSON 1.727

Note: Significance at: *1, * *5 and * * *10 percent levels

Table VI.Fixed effect regression –capital structure andconcentration (promoters’holding)

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We have argued that, ceteris paribus, firms having concentrated shareholdingshould go for debt financing as a means of mitigating collective action problemconfronted by dispersed shareholding. Moreover, bank and financial institutiondominated debt financing system in India finds comfort level in concentratedshareholding as interest of the block shareholding groups being more aligned – thelatter provides collateral security in personal capacity to address and mitigateagency problem associated with debt financing. We have also reasoned that theentrenched managers of the firms having diffused shareholding should go forinternal accrual for financing (if profit permits) to continue to enjoy managerialdiscretion. If the profit is insufficient the entrenched managers should go for issue ofshares rather than debt financing to avoid monitoring by the lenders in a manner sothat concentration of shareholding can be avoided at the same time. We have alsoargued that ownership structure impacts as well as gets impacted by capitalstructure. That is there should be a two way relationship between debt andownership structure.

Our empirical result on Indian firms suggests that the ownership structure doesimpact capital structure but not the vice versa. Consistent with our argument wefind that the leverage is positively related to concentrated shareholding but has anegative relation with diffuseness of shareholding after controlling for profitability,risk, tangibility, growth and size. Our result is consistent with what Kayhan (2008)posits – “entrenched managers” may retain rather than pay out earning and showpreference for issue of equity over debt – in order to achieve a conservative capitalstructure that improves their job security. We further provide an argument that incase of dispersed shareholding, monitoring by the shareholders is less andmanagerial discretion is more, hence entrenched managers motivated byself-interest would like to avoid or prevent monitoring by creditors as well, andtherefore, would prefer internal funding over debt financing. Besides shareholding,we also find in conformity with the pecking order theory – that the firms havinghigh profitability use less debt. We also incidentally notice that – tangibility isnegatively related to leverage. During the study period (2004-2009), India witnesseda robust economic growth, the sample units earned steady profit till 2008 and hadnarrow range bound leverage. In the backdrop, continuous decline of tangibility

Explanatory variable Coefficient t-statistics

Constant 0.629 4.620 *

PROFIT 20.287 23.161 *

RISK 20.969 20.811TAN 20.098 21.856 * * *

GROWTH 0.017 1.274SIZE 20.019 21.254NPSH 20.319 22.255 * *

R 2 0.849F-value 19.618DURBIN-WATSON 1.727

Note: Significance at: *1, * *5 and * * *10 percent levels

Table VII.Fixed effect regression –

capital structure anddiffuseness

(non-promoters’ holding)

Capital structure

69

of the sample units (evident from descriptive statistics in Table II) with nosignificant decline in leverage may mean financial slack in the form of cash or cashequivalents, investment in other companies, merger and acquisition and so on thatmay not be value enhancing always – indicative of possible agency problem of freecash flow in line with Jensen’s (1986) argument. However, the finding is onlyincidental and leaves ample room for further research.

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About the authorSantanu K. Ganguli is a Chartered Accountant (FCA) and holds a PhD (Finance). He is aProfessor of Finance and Accounting at the Institute of Management Technology –Ghaziabad, India. He has been a visiting faculty of the University of Warsaw, Poland (2010),IIM – Calcutta (2001-2006) and Institute of Chartered Accountants of India. His researchinterest lies in corporate governance, capital structure, dividend policy, market basedaccounting research and firm valuation. He has conducted extensive managementdevelopment programmes on corporate finance, valuation and accounting standards andhas published and presented empirical papers, chaired sessions and acted as key note speakeron corporate finance and firm valuation internationally. Santanu K. Ganguli can be contactedat: skganguli@imt.edu

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